Key topics

Chapter 9
Applying the Competitive Model

Applications & Problems
•
•
•
•
•
•

occupational licenses and zoning
trucking
restriction on entry across countries
FTC fights bans of Internet sales of wine
government barriers on entry: milk
recent fights over barriers to trade

Consumer’s welfare
• using a consumer's utility function is not
practical for 2 reasons:
• we don't know individuals' utility functions
• we cannot compare utilities across individuals

• instead, we measure consumer welfare in
dollars
• easier to measure than utility
• can compare dollars across individuals

1.
2.
3.
4.
5.

consumer welfare
producer welfare
competition maximizes welfare
policies that shift supply curves
policies that create a wedge between
supply and demand
6. comparing both types of policies: imports

Definition of welfare
• most people: welfare = government
payments to poor people
• economists: welfare = well-being of various
groups such as consumers and producers

Measuring consumer welfare
• consumer surplus (CS) from a good =
• benefit a consumer gets from consuming it (in $'s)
minus its price
• how much more you'd be willing to pay than you did
pay for a good

• demand curve contains this information
• demand curve reflects a consumer's marginal
willingness to pay: amount a consumer will pay

for an extra unit

1


Figure 9.1a Consumer Surplus

Graph individual's CS

(a) David ’s Consumer Surplus
p, $ per magazine
5

area under individual's demand curve and
above market price up to quantity that
consumer buys

a

b

4
CS1 = $2 CS2 = $1

c

3

Price = $3


2
E 1 = $3

E2 = $3

E 3 = $3

Demand

1

0

1

2

3

4

5
q, Magazines per week

Figure 9.1b Consumer Surplus

Graph market consumer surplus

’
p, $ per

trading card

area under market demand curve above
market price up to quantity consumers buy
Consumer
surplus, CS
p1

Expenditure, E

Demand
Marginal willingness to
pay for the last unit of output
q1

q, Trading cards per year

Consumer surplus from TV

Bruce Springsteen’s Gift to His Fans

• how much for you to "give up watching absolutely
all types of television" for rest of your life?

• 2002 average rock concert ticket price was $51
• $75 that Bruce Springsteen and the E Street Band
charged for their concerts was below the market
clearing price
• when tickets went on sale at the Bradley Center in
Milwaukee, 9,000 tickets sold in the first 10

minutes and all were gone after 20 minutes

• 23% would do so for $25,000
• 46% want at least $1 million
• 25% wouldn't give it up for $1 million

• 25% of those earning < $20,000/year wouldn't
give up TV for $1 million (50 years of earnings)
• thus, we use demand curves rather than asking
consumers

2


Scalpers

Springsteen’s pricing

• some tickets were available from scalpers, ticket
brokers, or on the Internet at higher prices
• a web site offered tickets for Dallas American
Airlines Center concert for $540 to $1,015
• according to a survey, the average price of a resold
ticket at the Philadelphia First Union Center
concert was $280

• says he set the price relatively low to give
value to his fans
• (in addition, he may have helped promote
his new album)

• assuming that he could have sold all the
tickets at $280, he gave almost $3 million of
consumer surplus to his Philadelphia fans
— double the ticket revenue for that concert

Figure 9.02 Fall in Consumer Surplus from Roses as Price Rises

Effect of a price change on CS

p, Â per stem
57.8

ã price increase reduces CS
ã could be caused by
• leftward shift of supply curve
• new government tax

A = $149.64 million

32
30

b
B = $23.2 million

C = $0.9 million
a
Demand

0


Where CS losses are large
a price increase causes a larger CS loss, the
• greater the initial revenues spent on the
good (further to the right is the demand
curve)
• less elastic is the demand curve

1.16 1.25
Q, Billion rose stems per year

Solved problem
• 2 linear demand curves go through the
initial equilibrium e1
• one demand curve is less elastic than
another at e1
• for which demand curve will a price
increase cause largest consumer surplus
loss?

3


Solved Problem 9.1

Producer surplus

p, $ per unit
Relatively inelastic demand (at e 1)


p2

B

A
C

e3

D

e2
e

p1

1

Relatively elastic demand (at e 1)

Q3

Q2 Q 1

Q, Units per week

1. supplier's gain from participating in a
market
2. difference between amount for which
good sells and minimum amount

necessary for seller to produce good
3. minimum amount a seller must receive to
be willing to produce is firm's avoidable
production cost (shut-down rule)

Figure 9.3

Measuring PS using supply curve

(a) A Firm’s Producer Surplus

Market supply curve

4

• producer surplus for a competitive firm or
market:
• area above supply curve (MC curve), below
price line, up to quantity sold

(b) Market Producer Surplus

’

Supply p , Price per unit

p, $ per unit

p
PS1 = $3 PS 2 = $2 PS 3 = $1


3

p*

2

Market price

Producer surplus, PS

1
MC1 = $1 MC2 = $2 MC3 = $3 MC4 = $4
0

Producer surplus and profit
PS = R - VC
• profit = revenue - (variable cost plus fixed
cost):
π = R - C = R - [VC + F]
⇒ PS - π = F
• which is zero in LR when F = 0
• PS differs from π by fixed cost

1

2

3
4

q, Units per week

Variable cost, VC

Q*
Q, Units per year

Interpreting producer surplus
• producer surplus is a gain to trade:
• in SR, if firm produces it earns
π = R - VC - F
• if firm shuts down it loses its fixed cost, F
• thus, PS = profit from trade - profit (loss)
from not trading is
PS = [R - VC - F] - [-F] = R - VC

4


Shocks and PS

Solved problem

• shocks change PS by same amount as π
(because fixed costs do not change)
• market PS measures effect of a shock on all
firms - so we don't have to measure π of
each firm separately

• if estimated supply curve for roses is linear,

• how much PS is lost when price of roses
falls from 30Â to 21Â per stem
ã so that quantity sold falls from 1.25 billion
to 1.16 billion rose stems per year

Solved Problem 9.2
p, ¢ per stem

E = $4.05 million

30

Common measure of welfare

Supply

a
D = $104.4 million

21

• welfare = consumer surplus + producer
surplus
W = CS + PS
• weights well-being of consumers and
producers equally (value judgment)

b
F


0

1.16

1.25

Q Billion rose stems per year
,

Welfare maximized at
competitive output
• producing more or less than competitive
level reduces welfare
• competition maximizes welfare because
p = MC in competitive equilibrium

Figure 9.4 Why Reducing Output from the Competitive Level
Lowers Welfare

p, $ per unit

Supply

A
p
MC

1

2


= p1

e2
B
D

C
E

e1
Demand

MC 2
F
Q2

Q 1 Q, Units per year

5


Figure 9.5 Why Increasing Output from the Competitive Level
Lowers Welfare

Deadweight loss (DWL)
p, $ per unit

Supply
MC 2


A

MC 1 = p 1
p2

C

e

1

B

DE

drop in welfare due to loss of surplus by one
group that is not offset by a gain to another
group from an action that alters a market
equilibrium

e2
Demand

F
G

H
Q1


Q2

Q, Units per year

DWL if too little produced
• producing < competitive output ⇒ DWL
• consumers value extra output by more than MC
of producing it
• DWL is opportunity cost of giving up some of
this good to buy more of another good

Deadweight loss of Christmas
• efficient gift: recipient values gift as much as it
cost giver
• DWL = price of gift – value to recipient
• according to Yale undergraduates, DWL is
between 10% and 33% of value of gifts

• market failure (DWL) is inefficient
production or consumption, often due to
p > MC

DWL of Christmas (cont.)
• gifts from friends and "significant others" are most
efficient
• noncash gifts from members of extended family
are least efficient (1/3 of value is lost)
• grandparents, etc. are most likely to give cash
• DWL is large


Government policies
• government policies tend to lower welfare
in competitive markets:
• welfare is maximized in competitive
equilibrium, so new equilibrium has lower
welfare

• U.S. holiday expenditures are $40 billion per year
• DWL of gift-giving holidays is between a 1/10 and 1/3
as large as estimates of DWL from inefficient income
taxation

6


We examine 2 types of policies
• limits on number of firms in a market,
which shift supply curve
• sales taxes, which create a wedge between p
and MC

Explanations for taxi regulation
• raises earnings of permit owners (taxi-fleet
owners), who lobby city officials
• some city officials contend that limiting
cabs allows for better regulation of cabbies'
behavior and protection of consumers (why
not regulate without restricting?)

Regulation of taxicabs

• every country except Sweden regulates
taxicabs
• many American cities limit number of
taxicabs

Effects of limiting number of
cabs
• raises market price
• lowers welfare creates DWL
• hurts consumers helps medallion owners
(but not cab drivers)

Figure 9.6 Effect of a Restriction on the Number of Cabs
(a) Cab Firm

Occupational licenses

(b) Market

p, $ per ride

p, $ per ride

AC 1

AC 2

MC
S2


A
p2

e2

p1

E2

p2

π

B
e1

C

p1

S1
E1
D

q1 q 2
q, Rides per month

n2 q 1

Q 2 = n2 q 2


Q 1 = n 1 q1

Q, Rides per month

• governments around world license:
doctors, lawyers, electricians, contractors,
beauticians,…
• usually current practitioners design tests to
prevent entry
• failure rate on California bar exam in 1993:
• 46% overall
• 47% of attorneys from other states

7


Zoning
• many cities frequently control number and
location of firms using zoning laws
• Berkeley's zoning ordinances
• limits number of restaurants to 31 in Telegraph Av.
area near Univ. of Calif. Berkeley
• limits number of chain book stores in certain areas
• designed to prevent these low-cost stores from driving
higher-cost, traditional book stores out of business

• Houston: no zoning

Restrictions on Entry across

Countries
• most countries restrict new businesses from
entering markets
• virtually every country requires potential
new firms to fill out certain forms and pay
fees to become a legal business
• some countries prohibit entry in certain
industries.

World Bank Survey

World Bank Survey II

• survey of entry restrictions in 85 countries
• found that ease of entry varied substantially
across countries

• To determine the cost of entry, Djankov, et al.
(2002) calculated the ratio of fees plus the cost of
time in applying as a percentage of per capita
annual gross domestic product (GDP)
• range across countries was enormous:

• it takes 2 business days to enter a typical
business in Australia or Canada
• 152 days in Madagascar
• average for the 85 countries surveyed was 47
days

Patterns in onerous restrictions

• rich countries have fewer restrictions than poor
countries
• countries with greater political freedoms, less
corruption, and smaller illegal sectors tend to have
fewer entry restrictions
• leaders of governments in poor, underdeveloped
countries generally set rules protecting existing
businesses from competition (to benefit friends,
relatives, or themselves, who own existing
companies) — e.g., Arafat and the Palestinian
Authority

• lowest ratio was < 0.5% for U.S.
• highest was > 4.6x per capita GDP in Dominican
Republic
• average was 47% of per capita GDP

FTC opposes Internet bans that
harm competition
• preventing Internet shopping raises the
prices of some goods
• in 2003, a FTC report concluded that ending
bans on interstate wine sales over the
Internet would save consumers as much as
21% on relatively expensive wines and
increase consumer choice

8



Existing regulations
• 26 states, including New York, Florida,
Massachusetts, and Pennsylvania, laws (many
dating from the Prohibition era) ban direct-toconsumer shipping from out-of-state, in part to
prevent sales to minors
• FTC concluded that shipping wine directly to
homes does not lead to more underage drinking:
many states require an adult to sign to accept wine
deliveries

Government barriers: Milk
when a federal court declared
unconstitutional a 50-year-old statute that
allowed only 5 wholesalers to sell milk in
New York City
• a new firm entered market
ã price per gallon fell 70Â
ã consumers saved $80 million a year

Entry barriers
• LR barrier to entry:
• an explicit restriction or a cost that applies only
to potential new firms
• existing firms are not subject to restriction or
do not bear cost

• barriers to entry limit ability of firms to
enter a market in response to a profit
opportunity


Government barriers: Factories
laws require
• new factories have extra features to prevent
pollution or avoid seismic problems
• exempt older factories

Trucking

Trucking regulation

• entry unregulated trucking market is easy
• as a result, unregulated trucking market has
a horizontal LR supply curve at minimum
of AC of a typical firm

• Motor Carrier Act of 1935 gave Interstate
Commerce Commission (ICC) control over
pricing and entry in interstate trucking
• in response to lobbying by industry it was
supposed to regulate, ICC granted truck
firms monopolies over some routes and
restricted entry on others
• drove up prices

9


Motor Carrier Act of 1980
• ended ICC's regulation
• increase in entry from 1977 to 1982


State regulation

• trucking rates fell 15-20% from 1980 to 1983 (saves
consumers $15 billion/year)
• 25-35% by 1985

• with end of federal regulations, state regulations
created bizarre rate differentials
• before trucking was partially deregulated in 1990
in California, sometimes less expensive to ship a
package from SF to Reno (deregulated interstate
route) than to ship it 15 miles from SF to Oakland
(an intrastate route)
• As of 1/1/95 federal law ended state differentials:
prohibited state or local agencies from regulating
"prices, routes or services" in trucking industry

Exit barriers

Job-termination laws

• # of for-hire trucks rose 17% (to 267,000)
• # of trucks in private trucking sector rose 65% (to
510,000)

• more efficient firms expanded; less-efficient firms
failed

• exit barriers make it difficult for a firm to

go out of business
• exit barriers keep number of firms in a
market high in SR low in LR

• Canada: employers must give advanced
notice of termination length of warning
varies with size reaching a maximum of 16
weeks for firms with more than 300
employees
• UK: advanced warning varies with length of
service ranging from 1 to 8 weeks for
workers with 15 or more years of service

Policies that create a wedge
between supply and demand
• sales taxes
• price controls
• quantity restrictions

Effects of a sales tax
•
•
•
•
•

higher price
hurts consumers:
∆CS < 0
hurts firms:

∆PS < 0
raises new tax revenue, ∆T = T > 0
welfare:
W = CS + PS + T
• change in welfare is
∆W = ∆CS + ∆PS + ∆T < 0

10


Figure 9.7 Welfare Effects of a Specific Tax on Roses
Supply

p, ¢ per stem
A
B

32
30
τ = 11

D

e2
C
E

Demand

21

F

0

Deadweight loss from wireless taxes

e1

1.16
1.25
Q, Billion rose stems per year

• federal, state, and local government taxes and fees on cell
phone and other wireless vary substantially across
jurisdictions
• median state tax is 10%
• median combined state and federal tax is 14.5% (about $91 per
year)
• California and Florida have even higher state taxes of 21%, so their
combined taxes are 25.5%, or $185 per year
• New York is nearly as high

• governments raise about $4.8 billion in wireless taxes.

Who loses

DWL large relative to other taxes

• marginal cost of supplying a minute of wireless
service is constant at about 5Â

ã thus, a tax inflicts consumer surplus loss but not
producer surplus loss (see Solved Problem 3.1)
• Hausman (2000) estimates DWL (efficiency cost)
from taxes is $2.6 billion
• for every $1 raised in tax revenue,

• estimates of the marginal efficiency loss per dollar
of income tax range from 26Â to 41Â
ã price elasticity of mobile telephones is -0.7, which
is more elastic than for other telecommunications
services
• tax on landlines creates almost no deadweight loss
because price elasticity for local landline phone
service is virtually zero (-0.005)

• average efficiency cost is 53Â for typical state (70Â in
high tax states)
ã marginal efficiency cost is 72¢ (93¢ in high tax states)

Figure 9.8 Effect of Price Supports in Soybeans

Welfare effects of a price floor

p, $ per bushel
Supply
p = 5.00

• price floor: minimum price at which a
consumer can buy
• many governments set price floors for

agricultural products using price support
payments

A

Price support
B

C

E

D

F

p1 = 4.59

e
Demand
G

3.60
0

MC
Qd =1.9

Q 1=2.1 Qs =2.2


Q g = 0.3
Q, Billion bushels of soybeans per year

11


Price floors and technical
progress

DWL reflects 2 distortions
• excess production: Qg is stored, destroyed,
or shipped abroad
• inefficiency in consumption
• p = $5 for last bushel of soybeans
• MC = $3.60

• since World War II, output per hour of farm
work rose nine fold due to technological
progress
• wheat and milk yields increased 2.5% per
year, year after year

Today’s subsidy program

Solved problem

• government sets a support price, p
• farmers decide how much to grow and sell
all of their produce to consumers at marketclearing price, p
• government gives farmers a deficiency

payment = p – p for every unit sold
• thus, farmers receive support price on their
entire crop

No Price
Support

Change

Consumer Surplus, CS
Producer Surplus, PS
Government Expense, -X
p, $ per bushel

1996/2002 Price
Support

A+B
D+G
0

A+B+D+E
B+C+D+G
-B-C-D-E-F

D+E = ∆CS
B+C= ∆PS
-B-C-D-E-F= ∆X

Welfare, W = CS + PS – X


A+B+D+G

A+B+D+G-F

-F = ∆W = DWL

S

A
price support

p = $5.00

B

C
e1

p1 = $4.59
4.5

D

E

p2 = $4.39

F


• government uses deficiency payment
approach
• what are the effects in the soybean market
of a $5 per bushel price support on
•
•
•
•

equilibrium price and quantity
consumer surplus
producer surplus
deadweight loss?

2001 agricultural support
payments
• $59 billion in Japan
• $95 billion in the United States
• $106 billion in the European Union

e2
D

G

2.1

2.2

Q, billions of bushels of soybeans per year


12


Farm support as fraction of
total receipts (OECD)
•
•
•
•
•
•
•

69% Switzerland
59% Iceland and Japan
35% EU
21% United States
17% Canada
4% Australia
1% New Zealand

Welfare effects of a price ceiling
• price ceiling: highest price that a firm can legally
charge
• in 1970s, U.S. government used price controls to
keep gasoline prices below market price
• long lines at gas stations and large DWL loss in
consumer surplus in California ($1985)
• $1.2 billion 12/1973 - 3/1974 price controls

• $800 million 5/1979 - 7/1979 controls

Solved Problem 9.4

Solved problem
What is the effect on the equilibrium and
welfare if the government sets a price
ceiling below the unregulated competitive
equilibrium price?

p, $ per pound

A
Supply
B
p1
p2

D
F

C
E
e2

1.
2.
3.
4.


government of (potentially) importing country
can use one of four import policies:
allow free trade: any firm can sell in this country
without restrictions
ban all imports: government sets quota = 0 on
imports
set a positive quota
set a tariff: tax (duty) on only imported goods

p, Price ceiling

Demand
Qs = Q2

Comparing both types of
policies: Imports

e1

Q1

Qd
Q, Pounds per year

U.S market for crude oil
assumptions for simplicity:
• transportation costs = 0
• U.S. is a price taker: supply curve of
potentially imported good is horizontal at
world price


13


Figure 9.9 Loss from Eliminating Free Trade
Demand
p, 1988 dollars
per barrel

Free trade vs. tariff

S a=S2
A
e2

29.04

B

14.70

• common types of tariffs
• specific tariffs: τ dollars per unit
• ad valorem tariffs: α percent of sales price

C
e1

S 1, World price


D

0

8.2 9.0

10.2

11.8

13.1

Imports = 4.9
Q, Million barrels of oil per day

Tariff

• taxes vs. tariffs
• almost 5 times more tax revenue would be generated by
• a 15% additional ad valorem tax on petroleum products
($34.6 billion)
• than by a 25% additional import tariff on oil and gas
($7.3 billion)

Tariff effects

• suppose government imposes a specific
tariff of τ = $5 per barrel of crude oil
• tariff creates a wedge: firms will not import
oil into US unless US price is at least $5

above world price of $14.70

• tariff protects U.S. producers from foreign
competition
• larger tariff ⇒ less is imported, hence
domestic firms charge higher price
• consumers lose; domestic producers gain
• loss is less than from a ban

Figure 9.10 Effect of a Tariff (or Quota)
p, 1988 dollars
per barrel

A

29.04

19.70
B

0

• -C = loss from producing 9.0 million barrels per
day instead of 8.2 million barrels per day

e2

e3

τ = 5.00

14.70

Interpretation of DWL

Sa =S 2

F

D

C

S3
e1

E

G

S1, World price

H

8.2 9.0

11.8

13.1

Imports = 2.8

Q, Million barrels of oil per day

Demand

• cost of producing extra 0.8 million barrels domestically
=C+G
• had Americans bought this oil at world price, cost
would have been only G

• -E = consumption distortion loss from American
consumers' buying too little oil
• U.S. consumers value extra output as E + H
• value in international markets is only H

14


Free trade versus a quota
• effect of a positive quota is similar to that of a
tariff
• gain to domestic producers are same as with a tariff
• but government gets no tariff revenues
• foreign exporters get what would be tariff revenues

• thus, DWL from quota > greater than under tariff

Rent seeking
• rent seeking: efforts and expenditures to gain a
rent or a profit from government actions
• producers lobby for trade protection

• they spend up to their potential gain

• some economists argue that government revenues
from tariffs are completely offset by
administrative costs and rent-seeking behavior

1 Consumer welfare
• CS = area under consumer's demand curve
above market price up to quantity that
consumer buys
• how much consumers are harmed by an
increase in price is measured by change in
CS

3 Competition maximizes
welfare

2 Producer welfare
• PS = area above MC and below demand
(price line) up to quantity produced
• PS = a firm's gain from trading
• PS = largest amount of money that you
could take from a firm's and it would still
produce
• PS = R - VC (= π in LR)

•
•
•
•


one standard measure of welfare:
W = CS + PS
more p is above MC, lower is W
in competitive equilibrium, where p = MC,
W is maximized

15


4 Policies that shift supply
curves
• governments limit # of firms by
• limiting number of firms (licensing)
• raising costs of entry or exit to new firms

• results
•
•
•
•

higher price
hurts consumers
helps existing firms
lowers welfare (DWL > 0)

5 Policies that create a wedge
between supply and demand
• policy creates a gap between price

consumers pay and price firms receive
• taxes
• price ceilings
• price floors

• consequently, p > MC and DWL

6 Comparing both types of
policies: Imports
• welfare highest with free trade
• welfare lowest with ban on imports
• if a tariff and quota produce same
equilibrium, tariff better for home country
as it produces tariff revenues for
government

16